Economic Strategy: 9 December 2015

About the author:

Author name:

By Michael Knox

Job title:

Chief Economist and Director of Strategy

Date posted:

09 December 2015, 4:04 PM

On 3 December, President of the European Central Bank, Mario Draghi, announced a further easing of policy for the European Central Bank. The market reacted negatively to the announcement. The Euro rose and the stockmarkets fell. Why did this happen?

In this issue we look at what Mario Draghi is attempting to achieve and what this may mean for financial markets, but especially for the Euro. On the face of it, the announcement that Mario Draghi made should not have been negatively received. He cut the European Central Bank deposit rate by 10 basis points to -0.3%.

We have noted in our presentations the close relationship between this deposit rate and the Euribor 90 day rate. The Euribor rate is the rate that banks lend to each other within the Euro area. We definitely expect that this cut in the ECB deposit rate will be followed by easier money in the interbank market in the Euro area. This will expand liquidity in the Euro area.

Mario also extended the period of operation of quantitative easing from October 2016 to "March 2017 or beyond".

Mario suggested that this program (the purchasing of 60 billion Euros of assets every month) would continue until the ECB had achieved its target of 2% inflation. He also noted that assets that were purchased by the ECB would be reinvested as they matured "for as long as necessary".

He also included purchasing of local government debt within the ECB program of quantitative easing. This means that the European Central Bank will continue to expand its balance sheet and when it stops purchasing new assets it will maintain its balance sheet at the same level by re-investing all the assets as they mature. This is very much a long term program of support for the Euro area economy.

So why then did the Euro go up upon this announcement? It could be just that the Euro is already very oversold. To understand why we must look at what central banks are attempting to achieve.

European growth rate has to speed up

The ECB is trying to achieve a 2% inflation rate for the Euro area economy. This inflation rate is almost 2% higher than its current level. In order to achieve this higher level of inflation, the European economy has to grow a lot faster. Economists have a concept called the potential growth rate of gross domestic product.

This is the growth rate which stabilises inflation. It is pretty easy to see that the growth rate which stabilises the Euro Area inflation at the ECB target of 2% is a lot higher than where European growth is now.

So in the end the European growth rate has to speed up relative to the US growth rate.

One of the things this means is the real demand for credit in Europe is going to be a lot stronger than the real demand for credit in the USA. This means that if both central banks are successful, then German 10 year bond yields are going to rise relative to US 10 year bond yields because the real demand for credit in the Euro area will rise relative to the real demand for credit in the US.

What this discussion tells you is that in the longer term, we are getting down towards the bottom of what the Euro should be worth and we are getting up towards the top of what the $US should be worth.

In Figure 1 above we show what this means in terms of relative valuations of the $US vs the Euro. What we then get in Figure 1 is the difference between our model estimate of the real value of the Euro and where the Euro is trading.

Our model suggests that the Euro right now is deeply undervalued. On 7 December, our model suggested that the Euro was 1.45 standard errors undervalued. This is even after its bounce in the last couple of days. This means we are getting to a point where the Euro will get so undervalued that it will stop falling. Where might this level be?

The Euro has only been in existence since 1999. In that time there have been two dramatic lows. The first was in October 2000. On this occasion it reached a point 2.24 standard errors below our model. The second occasion was in May 2012. On that occasion it reached a point 1.97 standard errors below our model. What we know is that the level of undervaluation we have currently reached in the Euro is only a fraction of a standard error away from its previous lows.

To simplify the matter, the Euro is currently at $US1.086. To reach the level of undervaluation comparable to October 2000, the Euro needs to fall to US99.9 cents. This means it needs to fall to parity. On the other hand, to reach the level comparable to May 2012, it needs to fall to $US1.029 cents.

This is only slightly below the level that it fell to on 2 December of $US1.055.

Conclusion

The objective of the ECB is to increase the growth rate of the Euro area economy to the point where it will achieve long term 2% inflation.

This means that the Euro area economy is going to speed up relative to the US economy. This means that in the long term, the Euro must go up relative to the $US. We are fast approaching a point where that process can begin.